Income inequality—the growing gap between rich and poor and, increasingly, middle and lower class—is now a fact of life in America. We must recognize this fact and learn to live with it because the available evidence indicates that it is not going away and could potentially get much worse.
Intelligent investors will take notice of this fact and start looking for opportunities to take advantage of it. Such opportunities abound in today’s economy, but they’re not necessarily the obvious ones.
The most obvious beneficiaries of growing income inequality are discounters. The interesting thing here is that the discounters most likely to profit from this development are not the ones you think.
Why Dollar Stores Will Not Benefit from Income Inequality
A popular school of thought is that the so-called small box discounters or dollar stores will benefit from a growing underclass. These dollar store operators include Family Dollar (NYSE: FDO), Dollar Tree (NASDAQ: DLTR), Dollar General (NYSE: DG) and Big Lots (NYSE: BIG). Such stores specialize in selling relatively small numbers of items at extremely low prices.
The big problem with this theory is that revenues in the dollar store segment have been flat for the last year or so. Family Dollar reported a TTM revenue of just $10.47 billion in November 2013 that rose to $10.55 billion in November 2014. Dollar Tree reported a TTM revenue of $7.851 billion in October 2013 that grew to $8.361 billion in October 2014, and Big Lots reported a TTM revenue of $5.27 billion in October 2013 that grew to $5.33 billion in October 2014. The only small box operator that reported respectable revenue growth was Dollar General, which reported a TTM revenue of $17.22 billion in October 2013 that grew to $18.46 billion in October 2014.
News stories indicate that some of the small box retailers are also struggling. Family Dollar had to close nearly 400 stores last year just to maintain its profitability. Its management eventually threw in the towel and sold out to Dollar Tree. Alco, a chain of almost 200 small box stores, shut down completely in January.
Dollar stores are not doing well in this economy for three reasons that many investors fail to consider. First they do not save a very precious commodity that many of today’s new poor and formerly middle class people often have very little of: time. By their very nature, dollar stores offer very limited selections; there are a lot of things you simply cannot get at the dollar store, including fresh produce, meat, prescriptions, gasoline, financial services, etc. That means you have to stop at two or three stores if you go to the dollar store.
A mother working two jobs and trying to raise a couple of kids might not have the time to stop at the dollar store, the grocery store, the gas station and pharmacy. She’ll head to the place that combines the attributes of all four: namely, Costco Wholesale (NASDAQ: COST) or a supermarket operator like Kroger (NYSE: KR). At either Costco or Kroger, our harried mother can fill her gas tank, pick up her prescriptions, buy the vegetables and pick up the laundry detergent.
The second reason why the unequal economy does not benefit dollar stores is that economically insecure people are much more conscious of their purchases. People who have to make their dollars go further are more likely to question the small sizes and limited quantities at the dollar store.
Small box stores by their very nature cater to those with more disposable income; the available data indicates that the income of average Americans has been falling for years. People have less money to spend, so they have to make the dollars they earn go further. That encourages frugality, and frugal people are more likely to go where they can get the most “bang for their buck,” which is Costco or Kroger.
Economic insecurity drives the third reason why people don’t want to shop at the dollar stores. A person who pushes a cart of cheap junk out of Dollar General feels poor. A person who pushes a pallet of giant bags or boxes of laundry detergent and food out of Costco feels middle class. That person feels smart because of his savings rather than ashamed to be shopping at “the dollar store.” In a bad economy, basic consumer psychology works against the dollar stores.
The revenue figures seem to bear out this hypothesis. Costco’s TTM revenue went from $101.22 billion in November 2012 to $106.46 billion in November 2013 to $114.49 billion November 2014. Kroger’s TTM revenue grew from $94 billion in October 2012 to $99.17 billion in October 2013 to $106.48 billion in October 2014.
Both Costco and Kroger are discounters, but they’re discounters that cater to the cash strapped middle class. Kroger has shown an impressive ability to discount in recent years; I recently found cans of broth and tomatoes, which normally sell for $1.30, selling at City Market, my local Kroger subsidiary, for 50¢. I also saved 30¢ a gallon on gas recently because I used my Kroger club card.
What Investors Need to Look for in an Age of Income Inequality
That means investors should look for those businesses that cater to the cash strapped and insecure middle class. Such chains help people save money but don’t take away their middle class social status.
A perfect example of such a chain is Chipotle Mexican Grill (NYSE: CMG), which offers a high-quality, handmade meal for a low price. A person who walks into Chipotle and buys a burrito feels smart for getting high quality at a low price. Not surprisingly, Chipotle has done well in the last year. Its TTM revenue went from $3.21 billion in December 2013 to $4.108 billion in December 2014. Nor is it a coincidence that McDonalds (NYSE: MCD), with its dollar menu, did poorly in the last year. McDonalds reported a TTM revenue of $28.11 billion in December 2013 that fell to $27.44 billion in December 2014.
The lesson here is obvious: investors should look for companies that provide low cost luxuries and high quality at a good price. This would include Starbucks (NASDAQ: SBUX), which saw its TTM revenue rise from $15.31 billion in December 2013 to $17.01 billion in December 2014, Netflix (NASDAQ: NFLX), Apple Inc. (NASDAQ: AAPL) and Sprouts Farmers Market (NASDAQ: SFM).
Those companies that can help sustain the illusion of a middle-class lifestyle will do well as both Costco and Apple have demonstrated in recent months. Businesses that remind people that they are poor have a hard time competing. Walmart Stores Inc. (NYSE: WMT) has had a hard time increasing its foot traffic in recent years. The retail giant reported that its same store revenue fell by .4% in the third quarter of 2014.
This bodes well for the company that is best at offering such an illusion: Amazon.com Inc. (NASDAQ: AMZN). Amazon is a discounter that eliminates the need to go to the discount store entirely. Amazon.com saw its TTM revenue rise from $74.45 billion in December 2013 to $88.99 billion December 2014.
It also bodes well for Walmart, which has expanded its online retail operations dramatically; the world’s largest retailer has constructed five new fulfillment centers that can hold up a half million separate pieces of merchandise for shipment to e-commerce customers. In other words, it is now possible to shop at Walmart without going to Walmart.
Basically, any company that offers high-quality merchandise or a high level of convenience at a good price is poised to profit in this economy. People want to save as much money as possible, but they don’t want to think of themselves as “poor”; income inequality, which makes people conscious of poverty, drives this trend.
If you forget conventional wisdom, even income inequality can become a value investing opportunity. Instead, you can grow your income by taking advantage of it.
Disclosure: the author owns shares of Kroger and conducts retail sales through Amazon.com.